The Growth of Finance, Financial

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28 Οκτ 2013 (πριν από 3 χρόνια και 8 μήνες)

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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 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


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

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


5

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



6

The Dot
-
Com Bubble (I)

7



Huge Loss of Stock Market Value




The Real Economy gets off easy

The Dot
-
Com Bubble (II)

8



5
trillions

$
market

cap

lost

by

tech

companies

between

2000 and 2002

The Dot
-
Com Bubble (III)

9



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)

10



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)

12


Approximate Financial Structure of U.S. Banking System:


Assets

= $15.0 T


Liabilities

= $13.6 T (
Deposits

= $8.5T, O
ther

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)

First impressions can be misleading…









13

The Subprime Crisis (IV)

14



Value of new loans collapsed by 47% in the 4
th

quarter of 2008!

Some Thoughts

15



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 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?

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

16

The Simple Economics of Leverage

17


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

18


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

19











Data: U.S. Flow of funds, 1963
-
2006

Non
-
Financial, Non Farm Corporations

20











Data: U.S. Flow of funds, 1963
-
2006

Commercial Banks

21











Data: U.S. Flow of funds, 1963
-
2006

Broker Dealer Banks (Inv. Banks)

22











Data: U.S. Flow of funds, 1963
-
2006

Important for the Financial Sector
as a Whole

23

The Leverage Asset Prices Nexus

24


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

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

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

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.

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!