Download Financial Innovation and Financial Fragility

The Growth of Finance, Financial
Innovation, and Systemic Risk
Lecture 2
BGSE Summer School in Macroeconomics, July 2013
Nicola Gennaioli, Universita’ Bocconi, IGIER and CREI
The Size of Finance
2



Astonishing rise of the share of U.S. GDP coming from the
financial sector since World War II (Philippon 2012)
This pattern is common to many other countries (Philippon
and Reshef 2013)
Much of this expansion comes from services to consumers
such as asset management and credit intermediation
(Philippon 2012, Greenwood and Scharfstein 2013)
The Size of Finance (cont’d)
3
Composition of Growth of Finance
4
Output of Financial Sector
5
Unit Cost of Finance (Income/Output)
6
The Size of Finance (cont’d)
7

This growth has proven difficult to explain:
Maybe relative cost of finance rose due to low productivity.
However, wages in finance grew faster than elsewhere.
 Conventional explanations: socially unproductive innovation and rent
seeking (e.g. Philippon 2012, Greenwood and Scharfstein 2013)

Source of Finance Income?
8



Key Question: Where do financial market players
obtain their remuneration from?
Standard theory: remuneration to specific asset
managers comes from their superior performance.
Problem: Professional money managers underperform
passive strategies net of fees (Jensen 1968)


Average mutual fund underperformance of 65 b.p. a year.
Investors pay substantial additional fees to brokers and advisors.
Professional Money Management
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
Performance is only part of what managers seek to deliver


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Managers/advisors mostly advertise trust, dependability, not past
performance (Mullainathan et al. 2008).
Some studies argue advisors provide intangible benefits or “babysitting”
GSV’s “Money doctors” paper (2013) presents a model
where this perspective is taken seriously.
Trust and Money Management
10

Key assumption: investors are too anxious to take risk on
their own. They need to hire a manager they trust.
Managers might have skills and knowledge, but in addition they
provide investors with comfort/peace of mind
 Finance is a service, and like many services is not only about
performance


Trust describes confidence in the manager based on:
Personal relationships, familiarity, connections to friends and
colleagues, communication and schmoozing, advertising...
 Trust does not derive from past performance
 Trust is not only security from expropriation (Guiso, Sapienza,
Zingales, 2004, 2008)
 Analogy with medicine, another service

Main results
11

Each manager can charge fees to his trusting investors.
 Managers
underperform the market net of fees.
 Fees are higher in riskier asset classes.
 Rational expectations: trust boosts risk taking and welfare.

If investors erroneously think that some assets are “hot”:
 Trusted
managers pander to beliefs to charge higher fees.
 They let investors chase returns by proliferating products
 Trust reduces the benefit of being contrarian by reducing
mobility of investors across differently performing managers
Finance and the Preservation of Wealth
12


GSV (2013) “Finance and the Preservation of Wealth”
paper uses the idea of trust to study the growth of finance.
More benign view: the growth of finance is a natural by
product of a maturing economy.
Embody our previous model of asset management (GSV 2012)
into a Solow-style growth model with diminishing returns to capital
 Use the model to shed light on the dynamics of intermediation,
financial sector income, and the unit cost of finance

The Basic Mechanism
13



Financial risk taking plays two functions:
 “Wealth preservation”: allows savers to move wealth forward
 “Growth”: allow savers to access growth opportunities
Key assumption (GSV 2012): Investors need trusted financial
intermediaries to take advantage of these investments.
 On their own, people utilize inefficient self-storage ( e.g. cash in
mattresses or gold).
 Savers are willing to delegate risky investment to a trusted
intermediary (“money doctor”) who gives them peace of mind.
Trust reduces the investor’s cost of bearing unfamiliar risks.
As the economy matures, K/Y rises. Savers are willing to pay
more for wealth preservation. This drives growth of finance.
Roadmap
14


Basic Setup (Households, Money Managers, Production)
Equilibrium Analysis with a fixed number of money
managers:
 Dynamics
of the Capital Stock
 Predictions on the Dynamics of Finance
 Shocks to Trust and Productivity

Endogenous entry of intermediaries
 Dynamics
of Fees and Unit Cost of Finance
Households
.
15

Overlapping generations of (measure 1 of) young and old
 Young
at
supply their unit labor at wage
 Wage is fully saved by investing in two assets:
 Safe
storage, which yields
at time
 Risky asset yielding an average return

and variance
Risky investment needs management. If saver hires
manager
at fee , his consumption at is:
Households (cont’d)
.
16

Mean variance preferences over portfolio return:
 Risk

aversion
is manager-specific and decreases in trust
Optimal delegated portfolio share with manager :
 Decreases
in fees, return from storage, risk
 Increases in expected return and trust
Money Management
.
17

Managers at equal distance
along the unit circle.
Trust of investor i in manager j decays with distance:
 Tradeoff:
moving away from closest manager may reduce fees
but will also entail less trust and thus risk taking

Optimal manager choice: Manager j wins over competitor
j’ all investors whose distance from j is less than:
Money Management (cont’d)
.
18

At symmetric equilibrium

The optimal (equilibrium) fee is equal to:
 Sharing
, the profit of j is equal to:
rule: fee increases in excess return
 Falls in “generalized trust”
, increases in specific trust
Production
.
19

At t firms produce:
 Value


added plus un-depreciated capital
: shock to value added and to capital stock,
and
Before learning , firms hire workers at fixed wage ,
and pledge to money managers (capital suppliers) the rest:
Production (cont’d)
.
20

Given the aggregate supplies
factor returns at time t are:
 The

and
, equilibrium
variance of the risky return is
Key properties:
 The
wage is the marginal product of labor
 The average return of the risky asset is 1 + the average
marginal product of capital
Equilibrium Dynamics
.
21

The law of motion for the aggregate capital stock
is:
 where:

Noteworthy Features:
 Difference
with Solow model: endogenous intermediation
 Intermediation increases in generalized trust
and decreases
in specific trust (increases in the number of managers)
Equilibrium Dynamics (cont’d)
.
22

Under some parameter conditions, the economy converges
to a steady state
and
such that:
 Risk
taking and thus the capital stock increase in the waste from
storage, in productivity and in the number of managers.
 Higher
waste from storage increases the excess return of the risky
asset. This increases supply of funds.
 Higher productivity increases the excess return of the risky asset and
the real wage. This increases demand and supply of funds.
 The higher is the number of managers, the higher is competition
among them. This reduces fees, risk taking and intermediation.
Equilibrium Dynamics (cont’d)
.
23

Convergence to the steady state:
 Higher
capital stock increases wages and savings, this increases
demand for intermediation, which further increases investment.


What are the transitional dynamics of the financial sector?
How does the financial sector react to shocks?
Transitional Dynamics
.
24
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Equilibrium fees fall as capital increases toward its s.s.:
The income share of finance goes up as capital
increases towards its s.s.:
Both results are due to decreasing returns to capital:
growing role of capital preservation vs. growth services
as K/Y increases toward the steady state
Reaction To Shocks
.
25

Suppose that capital is initially at steady state
:
 If
productivity permanently drops to
: on impact the
income share of finance increases, and goes to its original
level in the long run. The s.s. capital stock falls.
 If
trust permanently drops to
: on impact the income
share of finance drops, and it continues to drop until the
new steady state. The s.s. capital stock falls.

Productivity and trust shocks exert opposite short run
effects. Lower productivity renders capital preservation
more important, lower trust less important.
Empirical Predictions
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
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The finance income share increases over time with an
economy’s wealth to income ratio
The finance income share fluctuates with changes in
investor trust (goes down when trust in finance drops)
Unit fees for specific products fall over time
 Consistent
with the evidence in Greenwood and Scharfstein
(2012) for equity and bond funds.
Empirical Predictions
.
27

Dynamics of Wealth to income ratio for U.S.:

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Dynamics of Wealth to income ratio for other countries…
Empirical Predictions (cont’d)
.
29

Growing finance income share in the postwar period is
common to many countries (Philippon and Reshef 2013),
just as W/Y seems to be increasing for many countries
(Piketty and Zuckman 2012)
Empirical Predictions (cont’d)
.
30


Decline of finance after adverse shock to trust:
It took decades to rebuild the U.S. financial sector, much
longer than to rebuild productivity
Puzzling Feature
.
31

Unit costs (finance income/financial assets) has increased
despite falling unit fees:
Entry of New Intermediaries
.
32
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
This can be viewed as the result of competitive entry.
is endogenous. Entry condition:
Profit of each intermediary

Opportunity cost of time needed
to setup new intermediary
Under certain parameter conditions, the model with entry
converges to a unique steady state , ,
Entry of New Intermediaries (cont’d)
.
33

Rewrite entry condition as:

As the capital stock increases toward the steady state:
 The
unit profit for wealth preservation goes up
 Entry of new intermediaries takes place (/customization)
 Management fees fall (owing to decreasing returns and entry)
 Income share of finance increases
Entry and Unit Cost of Finance
.
34

Finance income over financial wealth (which includes
managed risky assets and non-intermediated storage) is:
 Fees
decrease over time, risk taking increases as closer (more
trusted) managers become available through entry

As new managers enter, the composition of investment
shifts toward higher fee/higher risk products (for which
proximity with manager is more important)
Robustness
35

Results are Robust to:
 Productivity
and population growth
 Irreversibility
of transformation of consumption into capital
(trading of capital between the elderly and the young)
Conclusions
36

By incorporating in a neoclassical growth model the idea
that savers are willing to pay fees to take financial risk
with trusted money managers we obtain:
Growth of finance income share of GDP as W/Y grows
 Fluctuation in size of finance with changes in investor trust
 Entry of financial intermediaries and customization
 Decline in fees
 Increase in unit cost of finance (fees x risk taking)


Without denying agency and other problems, finance
should grow as the economy matures, for preservation of
wealth becomes increasingly important